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Methodology for the Evaluation of Real Options in Real Estate Development

European Real Estate Society 20th Annual Conference. Theme M: REAL ESTATE DEVELOPMENT. Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios. 3rd-6th July 2013 - Vienna - Austria

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Methodology for the Evaluation of Real Options in Real Estate Development

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  1. European Real Estate Society 20th Annual Conference Theme M:REAL ESTATE DEVELOPMENT Methodology for the Evaluation of Real Options in Real Estate Development in AreasCharacterizedby UncertainScenarios 3rd-6th July 2013 - Vienna - Austria Vienna University of Economics and Business Research Institute for Spatial and Real Estate Economics Paperauthors: Marina BRAVI, Stefano ROSSI, Antonio TALARICOPolytechnicof Turin Speaker: Stefano ROSSI Polytechnicof Turin

  2. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios The real estate system 1 DEVELOPMENT INDUSTRY SPACE MARKET REAL ESTATE DEVELOPMENT PROJECT SUPPLY (Landlords) DEMAND (Tenants) LOCAL AND NATIONAL ECONOMIES FORECAST FUTURE YES Rent and occupancy Isdevelopmentprofitable? ASSET MARKET CASH FLOW SUPPLY (Ownersselling) FORECAST FUTURE CONSTRUCTION COSTS INCLUDING LAND PROPERTY MARKET VALUE EXPECTED RETURN DEMAND (Investorsbuying) European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  3. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Developmentprojects 1 • The developmentphaseisquiteriskyfortworeasons: • itisnotknownforcertainwhatoccupancywillbeachievedwithinwhatperiodoftime and at whatrental rate, or at what price the building willbe sold; • developmentprojectsinherentlycontain ‘operationalleverage’; evenif the project isfinancedentirelywithequity and evenifitisentirelypre-leased, becausetheyhave high fixed or committedcosts relative topotentiallyvariablerevenues. • Investments in stabilizedpropertieshave no operationalleverage, because the investmentscostoccursentirely al time 0. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  4. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Developmentprojects 1 • Costoflandacquisition • Constructioncosts • Selling Benefits Sacrifices Time European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  5. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Developmentprojects 1 Development project phaseswith relative expectedreturn Expectedreturn E0[r] Stabilizedoperation Constructionphase Time Developmentcompletion Landpurchase European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  6. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Volatility in landprices 1 • So: • whatdetermineslandvalues? • whatcauseslandpricestomove up and down? • We can simulate thousandsofpossible project scenariosbymeansof the Monte Carlo analysisto compare the riskprofileof a fullyoperationalproperty and a development project (tobuildanessentiallyidenticalproperty), calculatingtheirPresentValues. • Each project scenario iscreatedbymeansof a Normalprobabilitydistributionfor the key input, reversionvalue, whileconstructioncostisassumedtobedeterministic. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  7. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Volatility in landprices 1 Ifweanalize the probabilitydistributionof the PV results, weseethat, although the magnitude of change is the same… European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  8. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Volatility in landprices 1 …the impact on expected return is significantly different, expecially in terms of standard deviation! European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  9. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Volatility in landprices 1 So, changes in expected net operatingincome and/or reversionvalue and theirgrowthrates are the basiccausesofvolatility in landprices. Development project Stabilizedproperty Risk free European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  10. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Volatility in landprices 1 Ifthisrelationshipdoesnothold, thenthere are ‘supernormal’ (disequilibrium) profits (expectedreturns) tobemadesomewhere and, correspondingly, ‘subnormal’ profitselsewhere, accross the marketsforland, stabilizedpropertyand bonds. Development project Stabilizedproperty Risk free European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  11. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Inflexibility of DCFA 1 The mostimportant and commonlyusedmetric in the decision-makingprocessis the net presentvalue (NPV) whichis the differencebetween the presentvalueof the expectedpayoff and the project investment. If the project NPV issignificantly positive or significantly negative, evenwith a probabilisticpayoff, the decisiontoinvest or nottoinvestwouldbeobviousif the wholerangeof the expectedpayoffvaluesiseither far higher or far lower. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  12. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Inflexibility of DCFA 1 Expectedpayoff > Investmentcost: the project shouldbeundertaken A European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  13. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Inflexibility of DCFA 1 Expectedpayoff < Investmentcost: the project shouldberejected B European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  14. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Inflexibility of DCFA 1 Butsometimesthereis a ‘gray zone’ where the investmentvaluesmaybe in the rangeof the expectedpayoffvalues, making the decisionsomewhatdifficult. C European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  15. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Optionality ofland 1 Ifflexibility can beembedded in realproperty in a way whichallows the investmenttorespondaccordinglytofavorableconditions in the future, or toavoidpotentially negative outcomes, the assetmayinherentlybe more valuable. Butthisflexibilityisnotaccountedfor in the DCF approach, whichiseffective at the ‘extremes’. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  16. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Optionality ofland 2 The economic definition of ‘land value’ is based on nothing more or less than the fundamental capability that land ownership gives to the landowner : the right without obligation to develop (or redevelop) the property upon payment of the construction cost. Built property is underlying asset and construction cost is exercise price. In essence, all real estate development projects are real options, though in some simple cases the optionality may be fairly trivial and can be safely ignored. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  17. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios 2 Brownfields A brownfield site is a pieceoflandwhichwaspreviouslyusedfor industrial or commercial purposes. Suchplotsoflandmaybecontaminatedbyconcentrationsofhazardouswastes or pollution, and have the potentialtobereused once cleaned up. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  18. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios 2 Brownfields In Italy, the lawstatesthatif the partiesresponsiblefor the contamination do notprovidedirectly, the procedures and actionsreferringto the clean up of the brownfieldswillbecarried out ex officioby the municipalitywithterritorialjurisdiction and, ifthisfails, by the Region (L.D.n° 152 ofApril, 14th 2006). In this case, the public actorthatreplaces the private onefor the implementationofremediationcouldclaimdirectlyagainst the reclaimed area. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  19. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios 2 Brownfields • Investmentdecisionsconcerning the redevelopmentofthesesites, in short, are affectedbytwocriticalvariables: • remediationcosts; manycontaminatedbrownfieldssites sit unusedfordecadesbecause the costofcleaningthemtosafestandardsis more than the landwouldbeworthafterredevelopment; • market valueof the area after the environmentalrecoveryhasbeencompleted. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  20. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  21. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  22. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  23. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  24. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  25. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  26. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  27. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  28. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  29. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 The growthof the weightof the remediationcosts, comparedto the estimatedlandvalue, willnot render the project feasible. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  30. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  31. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  32. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  33. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  34. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  35. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  36. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  37. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  38. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  39. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 Moreover, in the eventthat the remediationcosts are almostequalto the market valueof the reclaimedland, the DCFA becomesaninflexibletool, wherein the feasibilityisdifficultto test. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  40. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Riskprofile ofbrownfields 2 In addition, high volatility in expectedrents and/or expectedreturnforstabilizedpropertiesmakesthingsevenworse. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  41. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios The valueof deferraloption 2 If and whenanupswingoccurs in the property market, the owner can choosetodevelop the propertymakingprofits, otherwisenot, therebyavoidingpotentiallosses. Itisthereforenecessarytocompute the valueof the deferraloption, whichisassociatedwith the decisiontoclean-up the land, giventhat the remediationcostis the exercise price and the valueof the underlyingassetcorrespondsto the valueof the landasnotreclaimed. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  42. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Black-Scholes model 2 The basicassumptionisthat the land market value at the end of the clean-upprocessisequalto the market valueof a landthatdoesnotrequireremediation. The incurredinvestmentby the landownerhas the purposeofincreasing the land market value, in ordertomakeit competitive in comparisonwithotherpropertiesthathave the samecharacteristicsbutwhich are notpolluted. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  43. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Black-Scholes model 2 • The Black-Scholes formula computes the valueof the deferraloption: • C = N(d1)S0 – N(d2)X exp(-rT) • where: • Cis the valueof the deferraloption; • S0is the presentvalueof the underlyingasset (landvalueasnotreclaimed); • Xis the exercise price (remediationcosts); • ris the risk-free interest rate; • Tis the expirationtimeof the option; • d1 = [ln(S0/X) + (r + σ2/2)T]σT1/2; • d2 = d1 - σT1/2; • N(d1) and N(d2) the valueof the normalstandardizeddistributionof d1 and d2. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  44. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Black-Scholes model 2 Probabilitydistribution of PV ofrevenues Probabilitydistribution of PV ofcosts - C = N(d1)S0 N(d2)X exp(-rT) European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  45. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Timevalue ofmoney 2 When the investmentdecisionmaybedeferred, the possibilityofdeferralgives rise totwoadditionalsourcesofvalue: wewouldalwaysratherpaylaterthansooner, all else beingequal, becausewe can earn the timevalueofmoney on the deferredexpenditure; howmuchmoneyisthat? PV(X) = X/(1+ rf)t So, if NPV can beexpressedas ‘NPV = S – X’, we can rewriteitusing PV(X) insteadofX: ‘modified’ NPV = S - PV(X) ≥ NPV European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  46. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Timevalue ofmoney 2 Insteadofexpressingmodified NPV as the differencebetween S and PV(X), let’s create a newmetric: NPVq = S/PV(X) Where ‘q’ remindsusthatwe are expressing the relationshipbetween S and PV(X) as a quotient. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  47. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios 2 Volatility whilewe are waiting, the world can change; specifically, the valueof the landweintendacquire (and itsexpectedreturn) maychange and affectourinvestmentdecisionfor the better. Thatpossibilityisveryimportant, butnaturallyitis more difficulttoquantifybecausewe are notactuallysurethatlandvaluewillchange or, ifitdoes, what the future valuewillbe. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  48. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios 2 Volatility We are talkingaboutvolatility: it can beestimated on the basisof the risk (standard deviation) associatedwith the expectedreturnof the development project European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  49. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios New call-option metrics 2 Together, ourtwonewcall-optionmetrics, NPVq and σt1/2, containall the information neededtovalue the investmentas a Europeancalloptionusing the Black-Scholesmodellocatingopportunities in two-dimensionalspace. European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

  50. Chapter Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios Locating the optionvalue 2 We can locate investmentopportunities, the optionvalue, in thistwo-dimensionalspace… NPVq 1,00 Lowervalues Highervalues Lowervalues Calloptionvalueincreases in thesedirections σT1/2 Highervalues European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

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